Which mortgage should I pay down first?

44 Replies

Deryck, is maximizing return on equity one of your real estate goals?  Divide your annual income from the property by the equity in the property.   Sensitize that based on how much equity you will have after you pay down a certain amount of debt.  ROE falls as leverage falls.  With your super low interest rates, paying down debt faster than the amortization schedule calls for is illogical from a return on equity perspective.  If debt makes you anxious and unhappy, then of course pay it off as fast as you can, but don't do it because it's a wise investment decision.

@Deryck C. Assuming financing is equal and the amount to pay off is equal, I would pay down the high cash flow first. This will allow you to “snowball” your payoff of both properties faster. In addition, there are tax advantages to both, but again assuming your goal is simply to pay off your mortgages, the snowball method would be the best.

@Colin March this is the best comment I’ve read in a long time. Everyone considers return on investment, but no ever considers return on equity. It’s one of the most important factors to consider. I just went to dinner at a local “historic landmark” restaurant on many acres with ponds, streams, etc. and asked how they were making money paying for all this? The response was “they’ve owned it a long time and got the land for cheap.” To me you can’t factor what you paid in this situation, you need to consider what the grounds are worth. If they’re worth a few million dollars and they’re only making a modest income (they have very few tables in a cottage) it’s a horrible return on equity. Obviously a resturant like this may be a labor of love, but the fact stands, if you sold it and reinvested the money almost anywhere else it would produce a higher return.

As far as paying down the debt, I don’t pay down any debt and my tenants don’t either! All of my loans are interest only. On a bad deal with poor cashflow to begin with, interest only will double your cashflow. On a good deal (in my market) interest only will increase cashflow by 30%+. That extra cashflow can be used to buy more property or invest in other areas like stocks, etc.

Originally posted by @Steve Vaughan :
Originally posted by @Deryck C.:

Hi investors, If you can pay down a mortgage, which one would you pay down aggressively first, a rental that has high appreciation and little cash flow, or the rental that has a higher cash flow but little appreciation? Thanks in advance

If rates and terms are the same and you are done expanding,  I'd pay off the lowest balance first.  

The type of loan mattered to me more than which same-type asset.  Pay off hard money, commercial, oddball, private, seller-financed, adjustable, callable, higher rate (6%+) etc in that order.  Done over a dozen that way.

 

Thank you all for the outpour of advice from this community! 

To answer your question Steve and Theresa, I think I'm done expanding as I depleted all my savings to buy these 2 properties, I don't think I can scale to 5+ properties, or maybe not in a very long time since I'm only a teacher and don't make much. If I do pay down a mortgage I agree with Tyler Williams & Khaled Dorry, "pay off the lower balanced first", and what Joshua Morgan said, "pay down the higher cash flow first", which is the Oklahoma house, then pay off the Arizona house after. I think I will be happy with both houses payed off by the time I retire

If AZ has a lot of equity, have you considered selling and doing a 1031 tax deferred exchange to buy multiple properties in OKC that cash flow great? I've done a 1031 before and I'm considering doing it again with properties that have a lot of equity. 

There's few philosophical thinking from all the answers above:
- Pay down debt, Dave Ramsey's style
- Do nothing
- Keep expanding or 1031.

You may need to factor in the macroeconomy as well and your future planning as well, such as kid college education and such. Do you have primary that still has mortgage ?

 What we know from macroeconomic pov  is :

- home appreciation will be there for years, at least until 2024
- inflation will be rampant and value of money is declining. Your hundred dollar buy less today than 2 years ago
- most asset will have long appreciation anyway especially real estate property as way to hedge inflation and possible currency devaluation
- cash flow is always good especially if property located in appreciating market

Originally posted by @Colin March :

Deryck, is maximizing return on equity one of your real estate goals?  Divide your annual income from the property by the equity in the property.   Sensitize that based on how much equity you will have after you pay down a certain amount of debt.  ROE falls as leverage falls.  With your super low interest rates, paying down debt faster than the amortization schedule calls for is illogical from a return on equity perspective.  If debt makes you anxious and unhappy, then of course pay it off as fast as you can, but don't do it because it's a wise investment decision.

 Here's another way of looking at maximizing the return on your equity.

When you buy a property, and put 20% down, you are getting a property valued at 5 times what you paid for it (assuming positive CF).  That 20% is equity you paid for.  When a property increases in value (appreciates), your equity increases equal to the increase in appreciation.  That's at a 1 to 1 value.  So, as your property appreciates, it is actually reducing the value of your equity.

Example:  PP = $100k; 2% DP = $20k
1 - At purchase, property value is $100k, and equity is equal to DP = $20k...a 5 to 1 value to equity ratio.
2 - If property appreciates to $120k, the equity is now = $40k, which makes the V to E Ratio now only 3 to 1.

Now, if you sold that property, and pulled out the equity an reinvested it as a 20% DP, that $40k would now bring in a PV of $200k...and be back at a 5 to  Ratio.  Your CF would also increase (should double).

If you were to pay all cash, that would mean you would have a 1 to 1 ratio...and it would take forever before you recovered your cash...which is what your total cost is.  When you pay only 20%, then that's your total cost of the property...again, assuming positive CF.

@Deryck C.

I was once the guy who wanted to get rid of all mortgages even for investment properties. The final answer is that it depends. Here are my thoughts:

1) if you are done and do not want to buy more investment properties, go ahead and pay down, but make sure you have at least 12 months of reserves before you pay down.

2) if you still want to buy more properties, i would shore up 12 months reserves, then anything north of that, go ahead and buy more. In short, low interest rate and at rate where we’re going, i think it’s good to lock in a 30 year fixed. So once rates increase you’ll be a happy camper and it’s arbitraging inflation rate.

Of course, let’s hope we are not the path of Japan where it’s low / negative interest rates for decades.....

@Joe Villeneuve and @Joe Splitrock answer in many threads is always the most practical (and basic), I like it because it really shows your interest and sympathy for investor. The answer for the return of Equity, is the most fabulous one. It's as simple as that.

@Allen Wu I'm started to think we're following Japaneese trajectory. The reason is many assets is too big too fail nowadays so they can't afford the property price to fall. This is obviously a very interesting subject that I'm mostly interested on.

Originally posted by @Joe Villeneuve :
Originally posted by @Anish Tolia:
Originally posted by @Joe Villeneuve:

Neither.  Your tenant is already doing this for you.  Why would you help?  You're not gaining anything.  You're actually adding to the cost of the property.

I am so tired of hearing that your tenants pay your mortgage. They DO NOT. YOU pay your mortgage. Otherwise you would not have make mortgage payments on vacant properties or when you have a deadbeat tenant. No bank stops foreclosures because your tenant didn't make the mortgage payment.

 

You don't get it. Of course it's your responsibility to pay the mortgage.  That's not what is meant by "your tenant pays the mortgage".  What that refers to is the source of funds to pay the mortgage.  When you have a vacancy, or negative CF, the source of funds is you.  When you have positive CF, the source of funds comes from the tenant, thus, the tenant IS paying the mortgage. 

I DO get it. The point is YOU carry the risk. Not the tenants. You can use your salary, or rent payments, or savings or inheritance or steal cash to make the mortgage payment. The source of the funds is meaningless and there is no distinction. Its all your money either way.  

Originally posted by @Anish Tolia :
Originally posted by @Joe Villeneuve:
Originally posted by @Anish Tolia:
Originally posted by @Joe Villeneuve:

Neither.  Your tenant is already doing this for you.  Why would you help?  You're not gaining anything.  You're actually adding to the cost of the property.

I am so tired of hearing that your tenants pay your mortgage. They DO NOT. YOU pay your mortgage. Otherwise you would not have make mortgage payments on vacant properties or when you have a deadbeat tenant. No bank stops foreclosures because your tenant didn't make the mortgage payment.

 

You don't get it. Of course it's your responsibility to pay the mortgage.  That's not what is meant by "your tenant pays the mortgage".  What that refers to is the source of funds to pay the mortgage.  When you have a vacancy, or negative CF, the source of funds is you.  When you have positive CF, the source of funds comes from the tenant, thus, the tenant IS paying the mortgage. 

I DO get it. The point is YOU carry the risk. Not the tenants. You can use your salary, or rent payments, or savings or inheritance or steal cash to make the mortgage payment. The source of the funds is meaningless and there is no distinction. Its all your money either way.  

 Correct.  You carry the risk, however, what is at risk here?  If it's the property, then it's more at risk without a lien against it since it's more exposed.  If the risk is your credit, then you are correct, but that's where the tenant's money plays a role.  If the risk is making the payments, then again that's where the tenant's money comes in.

Now, if you have negative CF and a loan, then you are committing financial suicide.

The discussion here is the math issue, and the math says, "use the debt".

What is a worse/better situation/risk to be in:

1 - Pay all cash for a property, an have to wait 10 plus years before you recover your cost and start to make a profit, and have 100% of your property exposed and at risk of losing it to a lawsuit, or...

2 - Pay only 20% for that same property, take less than 2 years to recover your cost and start making a profit,  have 80% of it under a lien which protects the property from a lawsuit since only 20% of the property is exposed.

...and it most certainly does matter where the money comes from to pay for the property.  When you pay 100% in cash, you are the one that is the source of ALL the funds to pay for the property.  That means the entire cost of that property is yours.  When you only put down 20%, and the rest of the funds come from the tenant, then your cost is only 20% of the property...the rest of it comes from the tenant.

If your loan is at 3.375% think of paying it down early as investing for a 3.375% rate of return. Personally I would be looking for a higher return. Not to mention its not liquid.

@Carlos Ptriawan I don't have any kids yet and no primary home, I still rent, houses here in Mountain View California are about 2 million. Since I don't have kids and a primary house, the idea of paying off my mortgages came up, just like @Brett Hennessy said, I agree with the plan to have of all your mortgages paid in x # of years so that you can retire and live off the cash flow. 

Thank you @Joe Villeneuve your examples are amazing and relatable! 

@Taylor Morrow Hey Taylor, yes. The loan itself allows you to put everything on Auto-pilot. All of my direct deposits, Venmo, ACH transfers etc. are automatically swept towards my line/remaining balance. The same is true for all my bill pays, they're swept off my line through my checking account. Even the interest cost is just added to the balance once a month, so I don't need to touch or think about anything. All I do is watch my balance go down ;) 

Haven't read through all the replies so this may have been mentioned. Look at your mortgage as the reversal of an investment. It is in your best interest (no pun intended) to lock in a good investment, specifically a high investment rate of return. Likewise, if you have to borrow money, it is in your best interest to lock in debt with as little a rate as possible. Conventional mortgages are government backed loans with often incredibly low rates. Therefore, if you are able to borrow money at a crazy low rate, don't make a bad investment decision by paying it down. Instead, let your tenants do that for you, invest your money into something else with a better return. Would you rather invest and get 8% return or pay down a debt with only 3% interest?

Forrest Faulconer